Investopedia: When evaluating terminal value, should I use the perpetuity growth model or the exit approach?

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When evaluating terminal value, should I use the perpetuity growth model or the exit approach?
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In discounted cash flow (DCF) analysis, neither the perpetuity growth model nor the exit multiple approach is likely to render a perfectly accurate estimate of terminal value. The choice of which method of calculating terminal value to use depends partly on whether an investor wishes to obtain a relatively more optimistic estimate or a relatively more conservative estimate. Generally speaking, using the perpetuity growth model to estimate terminal value renders a higher value.

DCF analysis is a common method of equity evaluation. DCF analysis aims to determine a company's net present value (NPV) by estimating the company's future free cash flows. The projection of free cash flows is done first for a given forecast period, such as five or 10 years. This part of DCF analysis is more likely to render a reasonably accurate estimate, since it is obviously easier to project a company's growth rate and revenues accurately for the next five years than it is for the next 15 or 20 years.

However, the structure of calculating NPV using DCF analysis requires a projection of cash flows beyond the given initial forecast period as well. This second calculation renders terminal value. Without including this second calculation, an analyst would be making the unreasonable projection that the company would simply cease operating at the end of the initial forecast period. The calculation of terminal value is an important part of DCF analysis because terminal value usually accounts for approximately 70 to 80% of the total NPV figure.

Calculation of terminal value is inherently problematic, however. Over longer periods of time, there is a greater likelihood that economic or market conditions – or both – may significantly shift in a way that substantially impacts a company's growth rate. The accuracy of financial projections tends to diminish exponentially as projections are made further into the future.

There are two principal methods used for calculating terminal value. The perpetuity growth model assumes that the growth rate of free cash flows in the final year of the initial forecast period will continue indefinitely into the future. Although this projection cannot be completely accurate, since no company grows at exactly the same rate for an infinite future period, it is nonetheless a reasonably acceptable projection of terminal value because it is based on the company's historical performance. The perpetuity growth model usually renders a higher terminal value than the alternative, exit multiple model.

The exit multiple model for calculating terminal value of a company's cash flows estimates cash flows by using a multiple of earnings. Sometimes equity multiples such as the price-to-earnings (P/E) ratio are used to calculate terminal value. A commonly used approach is to use a multiple of earnings before interest and taxes (EBIT) or earnings before interest, taxes, depreciation and amortization (EBITDA). For example, if companies in the same sector as the company being analyzed are trading at, on average, 5 times EBIT/EV, then the terminal value is calculated as 5 times the company's average EBIT over the initial forecast period.

Since neither terminal value calculation is perfect, investors can benefit by doing a DCF analysis using both terminal value calculations and then using an average of the two values arrived at for a final estimate of NPV.
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